The Hindu Business Line : It's risky to leave the risk unmanaged

MANAGEMENT of market risk is a major concern of the top management of banks. The board articulates market risk management policies, procedures, prudential risk limits, review mechanisms, reporting and audit systems. The policies should address the bank's exposure on consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on banks. The operating prudential limits and the accountability of the line management should also be clearly defined.

The board of directors has the overall responsibility for management of risks. The board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks.

Risk management committee, a board level sub-committee decides the policy and strategies for integrated risk management containing various risk exposures of the bank, including the market risk.

Monitoring: The asset liability management committee (ALCO), and `middle office' are responsible for monitoring the balance-sheet and ensuring that the market risk is within prudential limits of the bank.

ALCO is responsible for ensuring adherence to the limits set by the board as well as for deciding the business strategy for the bank in line with the bank's budget and decided management objectives. The role of ALCO includes:

* Product pricing for deposits and advances;

* Deciding on desired maturity profile and mix of incremental assets and liabilities;

* Articulating interest rate view of the bank and deciding on the future business strategy;

* Reviewing and articulating funding policy;

* Deciding transfer policy of the bank; and

* Reviewing economic and political impact on the balance-sheet.

ALCO support group is responsible for analysing, monitoring and reporting the risk profiles to ALCO. The group should prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance-sheet and recommend the action needed to adhere to the bank's internal limits.

The middle office is responsible for the critical functions of the independent market risk monitoring, measurement, analysis and reporting for ALCO.

Derivatives in risk management

Derivatives are used to protect treasury transactions from market risks. Derivatives are also used in managing balance-sheet risks, that is, asset-liability management.

Treasury uses derivatives mainly: to manage risk, including ALM risk; to trade based on the interest rate view; to cater to the requirement of the corporate customers

The value of derivatives is derived from an underlined market. The market may be financial market or commodity market.

All scheduled commercial banks are allowed now to enter into derivative contract for the limited purpose of hedging their risk in their underlying investment portfolio in a phased manner.

Banks have enhanced their expertise in derivative products and are now extensively using derivatives to hedge their exposure in secondary markets. With the increasing exposure in derivatives, a need is also being felt to devise uniform standard for accounting of such contracts in the books of account in order to enable the users of the financial statements have the correct picture of the risk that a bank institution is exposed to.

A bank may structure a derivative product to suit the individual client — based on its risk appetite, size of transaction and maturity requirement. Derivative products can be either over the counter products such as forwards, swaps, and so on, and/or exchange traded product such as currency feature, index option.

Interest rate risk: A case study

Failure of savings and loans organisations in US between 1979-1982 was due to short-term deposits used for funding long-term fixed interest rate assets. Subsequently, interest rates on deposits moved up abnormally resulting in a crisis and collapse of the organisations

Credit risk in Treasury operations

Significant magnitude of credit risk is inherent in Treasury operations. The proposals for investment need to be subjected to risk analysis.

The risk management for treasury operations focuses more on the non-SLR securities. SLR securities are generally not exposed to credit risk. Proposals for investments in non-SLR securities are to be subjected to same degree of risk analysis as any loan proposal with detailed appraisal and rating framework that factors financial and non-financial parameters.

All the issues, except where exemption are made on account of additional safeguards available, should be of investment grade rated by rating agencies.

Country risk

Country risk is the possibility that a country will be unable to service or repay its debts to foreign lenders in a timely manner.

In banking, this risk arises on account of cross-border lending and investment. The risk manifests itself either in the inability or the unwillingness of the obligor to meet its liability. Country risk comprises the following risks:

* Transfer risk arises on account of the possibility of losses due to restrictions on external remittances.

* Sovereign risk arises when sovereign entities claim immunity from legal process or might not abide by a judgment or when it becomes impossible to secure redress through legal actions. Normally, there will be no default by a sovereign.

* Cross-border risk arises on account of the borrower being a resident of a country other than the country where the cross-border asset is booked, and includes exposures to local residents denominated in currencies other than the local currency.

* Currency risk is the possibility that exchange rate changes will alter the expected amount of principal and return of the lending or investment.

At times, banks may try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers.

The risk, however, does not get extinguished, but gets converted to credit risk.

Operational risk in Treasury

Britain's oldest merchant bank, Barings Bank, collapsed in 1995 due to unauthorised trading by a single trader, Nick Leeson, General Manager, Barings Futures (Singapore). The collapse of the bank was mainly attributed to failure of systems and procedures of control.

The most serious failure was that Leeson effectively controlled both the front and back offices. There was no middle office. There was no single person within Barings responsible for supervising Leeson.

The major components and key elements of various operational risks in treasury operations are as follows:

People risk: Lack of key personnel, lack of adequate training/experience of dealer (measured in terms of opportunity cost/employee turnover), unauthorised access to the dealing room, tampering voice recorders and so on, nexus between the front and back offices, and so on.

Process risk: Wrong reporting of important market developments to the management, resulting in faulty decision-making, errors in entry of data in deal slips, non-monitoring of exposure in positions, loss of interest owing to the liquidity beyond prescribed limits, non-revision of card rates in cases of volatility, non-monitoring of closing and opening positions, wrong funding of accounts (wrong currency, wrong way swap), lack of policies, particularly in respect of new products.

Systems: Losses due to systems failure such as NDS — not maintaining secrecy of system passwords.

Legal and regulatory risk: Treasury activities should comply with the regulatory and statutory obligation.

The regulator is empowered to slap with penalty for any break/violation.

Mitigation: Formal policies need to be in place with trigger limits; stop loss limits; prudential limits; well defined procedures and check lists; effective internal controls and audit; insurance wherever possible; business process re-engineering to eliminate weak links in the process chain; prudential limits on investments in banks; cap on un-rated issues and private placements; sub-limits for PSU bonds, corporate bonds and guaranteed bonds; same degree of credit risk analysis in the case of any loan proposal; and more stringent appraisal for non-borrower issuers.

(Concluded)

(The first part of this article appeared on December 26.)

(Edited excerpts from D. Rangaswamy Memorial Endowment Lecture delivered by K. C. Chakrabarty, CMD, Indian Bank, on December 19, 2005.)